RATIONALE ANALYSIS OF DEMONETISATION

Economic growth slowed to 5.7 per cent in the first quarter of 2017-18 against 6.1 per cent in the preceding quarter. This was sharply below market expectations and came on the back of large-scale destocking undertaken by manufacturers ahead of the Goods and Services Tax rollout and the lingering impact of demonetization.

What does the latest data by CSO reveals?

The GDP recorded a growth of 7.9 per cent in April-June quarter last year. The April-June growth estimate, the lowest in at least five quarters, trended down on account of a sharp deceleration in manufacturing growth.

Trade, hotel, transport, communication and services related to broadcasting” witnessed a pickup by growing 11.1 per cent in April-June from 8.9 per cent last year, while growth in “public administration, defence and other services” (in Gross Value Added terms) was clocked at 9.5 per cent in April-June as against 8.6 per cent last year.

The Gross Value Added or GVA growth, which serves as a more closely watched estimate for quarterly growth, remained unchanged from the previous quarter at 5.6 per cent in April-June but fell sharply from the 7.6 per cent growth recorded in the April-June quarter last year.

Only three of eight sectors showed a pickup in GVA growth in April-June. Construction and financial services sectors recorded a slowdown with the GVA for “financial, insurance, real estate and professional services” sector growing at 6.4 per cent, down from 9.4 per cent last year.

GVA growth for the construction sector declined to 2.0 per cent in April-June from 3.1 per cent last year. GVA growth for “agricultural, forestry and fishing” declined marginally to 2.3 per cent from 2.5 per cent in the corresponding period last year, data showed.

Government view on demonetization

Finance Minister said that the demonetisation exercise had ended the “anonymity” around the money and identified it with its owner, enabling the government to bring it into the tax net.

The RBI Annual Report reveals that almost all demonetised notes have been returned to the central bank.

According to statement demonetisation has not completely eradicated black money but kept a check on a large part of it. The result of demonetisation has been that more and more people will now be compelled to come into the tax net, a fact evident from both direct and indirect tax numbers.

What are some arguments which prove failure of demonitisation to remove Black Money?

Demonetisation carried out on the incorrect premise that black money means cash. It was thought that if cash was squeezed out, the black economy would be eliminated. But cash is only one component of black wealth: about 1% of it. It has now been confirmed that 98.8% of demonetised currency has come back to the Reserve Bank of India. Further, of the Rs.16,000 crore that is still out, most of it is accounted for. In brief, not even 0.01% of black money has been extinguished.

Black money is a result of black income generation. This is produced by various means which are not affected by the one-shot squeezing out of cash. Any black cash squeezed out by demonetisation would then quickly get regenerated. So, there is little impact of demonetisation on the black economy, on either wealth or incomes.

The government now argues that it is good that black money has been deposited in the banks because those depositing it can now be caught. But the government had tried to prevent people from depositing demonetized currency by changing rules during the 50-day period.

The government changed the goalpost earlier in November 2016 when it suggested that the real aim of demonetisation was a cashless society. Now it says that idle money has come into the system, the cash-to-GDP ratio will decline, the tax base will expand, and so on. But none of these required demonetisation and could and should have been implemented independently. Further, anticipating the failure of demonetisation in 2016 itself, the government started saying that demonetisation is only one of the many steps to tackle the black economy.

The government’s argument that cash coming back to the banks will enable it to catch the generators of black income, and there will be formalisation of the economy, does not hold. Much of the cash in the system is held by the tens of millions of businesses as working capital and by the more than 25 crore households that need it for their day-to-day transactions.

The big failure of demonetisation is that it was carried out without preparation and caused big losses to the unorganised sector.

Why there was a need for a Cost Benefit Analysis Of Demonetisation?

The RBI Annual Report reveals that almost all demonetised notes have been returned to the central bank. This number does not include the old notes with District Central Cooperative Banks for the short window when they were of demonetisationallowed to accept deposits. It also does not include the notes within Nepal. The shortfall of Rs 16,050 crore between the notes in circulation when the notes were demonetised and those that were returned, could therefore also be made up once these notes are returned to the RBI.

There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a new breed of criminals with wealth obtained from illegal means. The total reduction in black money was therefore much smaller than what might have been envisaged.

International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system. In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.

• Demonetisation had provided an opportunity to encourage a shift to a digital economy. This will help bring transparency into the financial transactions of individuals and organisations thereby constraining corruption, criminal proceeds, money laundering and the finance of terrorism, which are all linked given the common channels employed for transferring funds. While demonetisation is likely to encourage it, incentives by the government for payment of bills can further encourage people to take up plastic and e-money options. This is also likely to be enhanced by the forces of market economy which are already offering money back options.